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Daily Agenda: Oil Market Continues to Feel Supply Glut

Japanese stocks sell off as yen rebounds; Sanofi reports drop in profits; New Hampshire votes in U.S. presidential primary.

Oil prices vacillated in overnight trading, with front-month futures contracts for West Texas Intermediate-grade crude testing levels below $30 per barrel before rebounding. In a report issued by the International Energy Agency today, estimates for the global supply of oil were hiked to account for increased production by Iran and Iraq, while other major producers both within and outside Organization of Petroleum Exporting Countries sustain current output levels. The agency now estimates that global production may exceed demand by more than 1.5 million barrels per day during the first half of 2016. IEA analysts conclude that the recent tour of major oil exporters by Venezuelan Oil Minister Eulogio Del Pino is unlikely to result in an accord to cull oversupply. The impact of the oil rout on equity and high-yield bond markets in the U.S. so far this year has been profound. Major energy companies have reported massive writedowns in the course of the current earnings season and the data suggests that the pain will not subside quickly. Research firm IHS has concluded that North American oil and gas producers will need to reduce spending by more than 30 percent in 2016 to regain balance even with a modest rally in energy commodity prices.

Sharp sell-off for Japanese stocks. In Japan, enthusiasm over that nation’s newly initiated negative rates has proven to be fleeting with the benchmark Nikkei 225 sliding by more than 5 percent before today’s close and the banks getting particularly hard hit. The decline come as multiple strategists have concluded that the Bank of Japan’s most recent steps to stimulate may not depress the yen as the central bank and markets had initially hoped, suggesting that Japan may have reached the limits of monetary policy. At the very least, the move threatens to undermine the credibility of the BoJ.

Bank of England wary over rising mortgage debt. In comments before an audience of business leaders today, Bank of England Deputy Governor Jon Cunliffe stated that the bank’s policymakers were watching the rapid increase in household debt in the U.K. carefully and were willing to take action if necessary. Cunliffe, while presenting at the British Property Federation Annual Residential Conference, concluded that if consumer debt expansion begins to exceed gross domestic product the Bank of England may be forced to act. The price of residential property and rents in the U.K. have skyrocketed in recent years as rates remain at historic lows.

New Hampshire primary voting begins. As voters line up at polling stations throughout the state, U.S. political analysts look for signals that a candidate will be able to pull ahead in closely contested races on both sides of the aisle. Results from Dixville Notch, the tiny New Hampshire town that is traditionally the first in the U.S. to vote in a primary—all nine residents gather to vote at midnight—favored Democratic Senator Bernie Sanders of Vermont and Republican Ohio Governor John Kasich for their respective parties’ nominations.

Sanofi profits fall.French pharmaceutical company Sanofi reported fourth-quarter financial results today that marked a sharp decline from earnings during the same period in 2014. Management ascribed adjusted decline of 6.5 percent year-over-year to increasingly competitive pricing for diabetes drugs in the U.S., who guided expectations for more challenges in the year ahead. While core business units suffered, the company’s biotech unit posted a 28 percent jump in revenues for the period.

Hong Kong protests continue. Clashes between protestors and police continued for a second night in the Mong Kok district, marring Lunar New Year celebrations. Dubbed the “fishball” revolt by local media outlets, the conflict arose after authorities attempted to clear the area of unlicensed food vendors during the holiday. The tone of the protests has since shifted towards pro-independence, similar to those during the autumn of 2014 with many students taking to the streets. The recent arrest of several satirical Hong Kong publishers critical of the government in Beijing has contributed to tensions.

Portfolio Perspective: Troubling Signals from Volatility Markets — Jim Strugger, MKM Partners

A high-volatility regime is synonymous with high risk. Over the course of the last 30 years, every major U.S. equity market correction and bear market has been contained within periods of structurally elevated volatility. And since our baseline is for the current regime to achieve the duration of historical analogs, this environment is likely to remain intact for several years.

But the mean-reverting nature of implied volatility suggests that even against this backdrop VIX, the futures curve and related metrics still need to cycle between the extremes of financial-market emotions. So the inability of VIX to sustain a decline below 20 and VIX futures curve to unwind its inversion following a shock that spiked spot to an intraday high above 32 on January 20 and closing high above 27 that same day is troubling.

This is particularly true given recent sharp moves in currency markets and resulting ripples across asset classes along with ever-widening credit spreads. We still would prefer to see cyclicality win out and for equity volatility to decline toward its elevated floor over the near term, but recent developments increase the risk of a downside tail event.

Managing that potential risk has to supersede playing for any potential upside in equities that would come with an unwind of the recent shock and hence we want to see a more sustained decline across volatility metrics — spot VIX below 20, VIX futures curve back in contango, GFSI Index off recent highs, at least—to be comfortable that a more pernicious event isn’t brewing.

Jim Strugger is a managing director and derivatives strategist for MKM Partners in Stamford, Connecticut.

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